Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS UNDER PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995; CERTAIN CAUTIONARY STATEMENTS
Certain portions of this report on Form 10-Q including the sections entitled “Overview,” "Strategy and Culture," "International Trade and Competition," "Seasonality," “Critical Accounting Estimates,” “Results of Operations,” “Currency and Other Risk Factors” and “Liquidity and Capital Resources” contain forward-looking statements. Words such as “expects,” “goals,” “plans,” “believes,” “estimates,” “continues,” “may,” “will,” and variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of future financial performance, our anticipated growth and trends in the Company's businesses, and other characterizations of future events or circumstances are forward-looking statements. These statements must be considered in connection with the discussion of the important factors that could cause actual results to differ materially from the forward-looking statements. Attention should be given to the factors identified and discussed in the Company's annual report on Form 10-K filed on February 27, 2013.
Overview
Expeditors International of Washington, Inc. is engaged in the business of global logistics management, including international freight forwarding and consolidation, for both air and ocean freight. The Company acts as a customs broker in all domestic offices, and in many of its international offices. The Company also provides additional services for its customers including value-added distribution, purchase order management, vendor consolidation, domestic time definite transportation services, cargo insurance and other logistics solutions. The Company does not compete for overnight courier or small parcel business. As a non-asset based carrier, the Company does not own or operate transportation assets, such as aircraft or steamships.
The Company derives its revenues from three principal sources: 1) airfreight services, 2) ocean freight and ocean services, and 3) customs brokerage and other services. These are the revenue categories presented in the financial statements.
The Company generates the major portion of its air and ocean freight revenues by purchasing transportation services on a wholesale basis from direct (asset-based) carriers and reselling those services to its customers on a retail basis. The difference between the rate billed to customers (the sell rate) and the rate paid to the carrier (the buy rate) is termed “net revenue” (a non-GAAP measure), “yield” or “margin.” By consolidating shipments from multiple customers and concentrating its buying power, the Company is able to negotiate favorable buy rates from the direct carriers, while at the same time offering lower sell rates than customers would otherwise be able to negotiate themselves. The most significant drivers of changes in gross revenues and related transportation expenses are volume, sell rates and buy rates. Volume has a similar effect on the change in both gross revenues and related transportation expenses in each of our three primary sources of revenue.
In most cases the Company acts as an indirect carrier. When acting as an indirect carrier, the Company will issue a House Airway Bill (HAWB) or a House Ocean Bill of Lading (HOBL) to customers as the contract of carriage. In turn, when the freight is physically tendered to a direct carrier, the Company receives a contract of carriage known as a Master Airway Bill for airfreight shipments and a Master Ocean Bill of Lading for ocean shipments. In these transactions, the Company is the primary obligor, is obligated to compensate direct carriers for services performed regardless of whether customers accept the service, has latitude in establishing price, has discretion in selecting the direct carrier and has credit risk. Therefore, the Company is the principal in these transactions and reports revenue and the related expenses on a gross basis.
For revenues earned in other capacities, for instance, when the Company does not issue an HAWB or an HOBL or otherwise acts solely as an agent for the shipper, only the commissions and fees earned for such services are included in revenues. In these transactions, the Company is not a principal and reports only commissions and fees earned in revenue.
Customs brokerage and other services involves providing services at destination, such as helping customers clear shipments through customs by preparing and filing required documentation, calculating and providing for payment of duties and other taxes on behalf of the customers as well as arranging for any required inspections by governmental agencies, and arranging for delivery. These are complicated functions requiring technical knowledge of customs rules and regulations in the multitude of countries in which the Company has offices.
The Company is managed along three geographic areas of responsibility: Americas; Asia Pacific; and Europe, Africa, Near/Middle East and Indian Subcontinent (EMAIR). Each area is divided into sub-regions which are composed of operating units with individual profit and loss responsibility. The Company’s business involves shipments between operating units and typically touches more than one geographic area. The nature of the international logistics business necessitates a high degree of communication and cooperation among operating units. Because of this inter-relationship between operating units, it is very difficult to look at one geographic area and draw meaningful conclusions as to its contribution to the Company’s overall success on a stand-alone basis.
The Company’s operating units share revenue using the same arms-length pricing methodologies the Company uses when its offices transact business with independent agents. The Company charges its subsidiaries and affiliates for services rendered in the United States on a cost recovery basis. The Company’s strategy closely links compensation with operating unit profitability. Individual success is closely linked to cooperation with other operating units within the network.
The mix of services varies by segment based primarily on the import or export orientation of local operations in each region. In accordance with the Company's revenue recognition policy (see Note 1. E.
to the consolidated financial statements in the Company's annual report on Form 10-K filed on February 27, 2013
), almost all freight revenues and related expenses are recorded at origin and shipment profits are split between origin and destination offices by recording a commission fee or profit share revenue at destination and a corresponding commission or profit share expense as a component of origin consolidation costs. The Asia Pacific segment is the Company's largest export oriented region and accounted for 50% of revenues and 40% of operating income for the nine months ended September 30, 2013. Asia Pacific's operating income as a percentage of revenue is lower than other segments due to the largely export nature of operations in that region.
Strategy and Culture
The Company has pursued a strategy emphasizing organic growth supplemented by certain strategic acquisitions. From the inception of the Company, management has believed that the elements required for a successful global service organization can only be assured through recruiting, training, and ultimately retaining superior personnel. The Company’s greatest challenge is now and always has been perpetuating a consistent global corporate culture which demands:
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Total dedication, first and foremost, to providing superior customer service;
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Compliance with Company policies and government regulations;
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Aggressive marketing of all of the Company’s service offerings;
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Ongoing development of key employees and management personnel via formal and informal means;
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Creation of unlimited advancement opportunities for employees dedicated to hard work, personal growth and continuous improvement;
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Individual commitment to the identification and mentoring of successors for every key position so that when inevitable change occurs, a qualified and well-trained internal candidate is ready to step forward; and
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Continuous identification, design and implementation of system solutions, both technological and otherwise, to meet and exceed the needs of our customers while simultaneously delivering tools to make our employees more efficient and more effective.
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The Company reinforces these values with a compensation system that rewards employees for profitably managing the things they can control. This compensation system has been in place since the Company became a publicly traded entity. There is no limit to how much a key manager can be compensated for success. The Company believes in a “real world” environment in every operating unit where individuals are not sheltered from the profit implications of their decisions. If these decisions result in operating losses, these losses must be made up from future operating profits, in the aggregate, before any cash incentive compensation can be earned. At the same time, the Company insists on continued focus on such things as accounts receivable collection, cash flow management and credit soundness in an attempt to insulate managers from the sort of catastrophic errors that might end a career.
Any failure to perpetuate this unique culture on a self-sustained basis throughout the Company provides a greater threat to the Company’s continued success than any external force, which would be largely beyond our control. Consequently, management spends the majority of its time focused on creating an environment where employees can learn and develop while also improving systems and taking preventative action to reduce exposure to negative events and risks. The Company strongly believes that it is nearly impossible to predict events that, in the aggregate, could have a positive or a negative impact on future operations. As a result our focus is on building and maintaining a global corporate culture of well-trained employees and managers that are prepared to identify and react to subtle changes as they develop and thereby help the Company adapt and thrive as major trends emerge.
The Company’s ability to provide services to its customers is highly dependent on good working relationships with a variety of entities including airlines, ocean steamship lines, and governmental agencies. The significance of maintaining acceptable working relationships with governmental agencies and asset-based carriers involved in global trade has gained increased importance as a result of ongoing concern over terrorism. As each carrier labors to comply with additional governmental regulations implementing security policies and procedures, inherent conflicts emerge which can and do affect global trade. A good reputation helps to develop practical working understandings that will assist in meeting security requirements while minimizing potential international trade obstacles, especially as governments promulgate new regulations and increase oversight and enforcement of new and existing laws. The Company considers its current working relationships
with these entities to be satisfactory. The airline and ocean steamship line industries have incurred significant losses in recent years and many carriers are highly leveraged with debt. This situation has required the Company to be increasingly selective in determining which carriers to utilize. Further changes in the financial stability, operating capabilities and capacity of asset-based carriers, space allotments available from carriers, governmental regulations, modernization of the regulations governing customs brokerage, and/or changes in governmental quota restrictions or trade accords could affect the Company’s business in unpredictable ways.
International Trade and Competition
The Company operates in 63 countries throughout the world in the competitive global logistics industry and Company activities are tied directly to the global economy. International trade is influenced by many factors, including economic and political conditions in the United States and abroad, currency exchange rates, and laws and policies relating to tariffs, trade restrictions, foreign investments and taxation. Periodically, governments consider a variety of changes to current tariffs and trade restrictions and accords. The Company cannot predict which, if any, of these proposals may be adopted, or the effects the adoption of any such proposal will have on the Company’s business. Doing business in foreign locations also subjects the Company to a variety of risks and considerations not normally encountered by domestic enterprises. In addition to being influenced by governmental policies concerning international trade, the Company’s business may also be affected by political developments and changes in government personnel or policies, as well as economic turbulence, political unrest and security concerns in the nations in which it does business and the future impact that these events may have on international trade and oil prices.
The global logistics services industry is intensely competitive and is expected to remain so for the foreseeable future. Consistent with continuing uncertainty in global economic conditions, concerns over volatile fuel costs, rising costs in general, political unrest and fluctuating currency exchange rates, the Company’s pricing and terms continue to be pressured by customers, carriers and service providers which resulted in a compression of the Company's 2012 margins. In the quarter ended September 30, 2013, the Company's ocean freight consolidation net revenue per container decreased 16%, as compared with the third quarter of 2012, primarily related to exports out of China.
The Company cannot predict what impact ongoing uncertainties in the global economy may have on its operating results, freight volumes, pricing, changes in consumer demand, carrier stability and capacity, customers’ abilities to pay or on changes in competitors' behavior.
Seasonality
Historically, the Company’s operating results have been subject to a seasonal trend when measured on a quarterly basis. The first quarter has traditionally been the weakest and the third and fourth quarters have traditionally been the strongest. This pattern is the result of, or is influenced by, numerous factors including weather patterns, national holidays, consumer demand, new product launches, economic conditions and a myriad of other similar and subtle forces. In addition, this historical quarterly trend has been influenced by the growth and diversification of the Company’s international network and service offerings.
A significant portion of the Company’s revenues are derived from customers in retail industries whose shipping patterns are tied closely to consumer demand, and from customers in industries whose shipping patterns are dependent upon just-in-time production schedules. Therefore, the timing of the Company’s revenues are, to a large degree, impacted by factors out of the Company’s control, such as a sudden change in consumer demand for retail goods and/or manufacturing production delays. Additionally, many customers ship a significant portion of their goods at or near the end of a quarter, and therefore, the Company may not learn of a shortfall in revenues until late in a quarter.
To the extent that a shortfall in revenues or earnings was not expected by securities analysts, any such shortfall from levels predicted by securities analysts could have an immediate and adverse effect on the trading price of the Company’s stock. The Company cannot accurately forecast many of these factors or estimate accurately the relative influence of any particular factor and, as a result, there can be no assurance that historical patterns, if any, will continue in future periods.
Critical Accounting Estimates
The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States requires that the Company make estimates and judgments. The Company bases its estimates on historical experience and on assumptions that it believes are reasonable. The Company's critical accounting estimates are discussed in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the
Company's annual report on Form 10-K for the year ended December 31, 2012, filed on February 27, 2013. There have been no material changes to the critical accounting estimates previously disclosed in that report.
Results of Operations
The following table shows the calculation of consolidated net revenues (a non-GAAP measure calculated as revenues less directly related operations expenses attributable to the Company's principal services) and the Company’s expenses for the three and
nine-month
periods ended
September 30, 2013
and
2012
, expressed as percentages of net revenues. Management believes that net revenues are a better measure than total revenues when analyzing and discussing management's effectiveness in managing the Company's principal services since total revenues earned by the Company as a freight consolidator includes the carriers’ charges to the Company for carrying the shipment, whereas revenues earned by the Company in its other capacities include primarily the commissions and fees earned by the Company. Net revenue is one of the Company's primary operational and financial measures that demonstrates the ability of the Company to manage sell rates to customers with its ability to concentrate and leverage its purchasing power through effective consolidation of shipments from multiple customers utilizing a variety of transportation carriers and optimal routings. Using net revenue also provides a commonality for comparison among various services.
The table and the accompanying discussion and analysis should be read in conjunction with the condensed consolidated financial statements and related notes thereto which appear elsewhere in this quarterly report.
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Three months ended September 30,
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Nine months ended September 30,
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2013
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2012
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2013
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2012
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Amount
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Percent
of net
revenues
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Amount
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Percent
of net
revenues
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Amount
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Percent
of net
revenues
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Amount
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Percent
of net
revenues
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(in thousands)
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Airfreight services:
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Revenues
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$
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628,116
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$
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622,678
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$
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1,891,459
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$
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1,900,131
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Expenses
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466,699
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471,947
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1,414,634
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1,437,301
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Net revenues
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161,417
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33
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%
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150,731
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32
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%
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476,825
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34
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%
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462,830
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34
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%
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Ocean freight services and ocean services:
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Revenues
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525,193
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549,250
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1,462,679
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1,502,584
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Expenses
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409,649
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432,518
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1,135,299
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1,177,919
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Net revenues
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115,544
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24
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116,732
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25
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327,380
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24
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324,665
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24
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Customs brokerage and other services:
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Revenues
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381,780
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359,736
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1,091,889
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1,045,271
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Expenses
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176,716
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162,061
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499,684
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467,406
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Net revenues
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205,064
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43
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197,675
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43
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592,205
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42
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577,865
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42
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Total net revenues
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482,025
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100
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465,138
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100
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1,396,410
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100
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1,365,360
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|
100
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Overhead expenses:
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Salaries and related costs
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261,613
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54
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252,899
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54
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765,599
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55
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748,956
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55
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Other
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74,099
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16
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67,140
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15
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212,401
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15
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213,631
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16
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Total overhead expenses
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335,712
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70
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320,039
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69
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978,000
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70
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962,587
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|
71
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Operating income
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146,313
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30
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145,099
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31
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418,410
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30
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402,773
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29
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Other income, net
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4,179
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1
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3,881
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1
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16,348
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1
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14,228
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1
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Earnings before income taxes
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150,492
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31
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148,980
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32
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434,758
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31
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417,001
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30
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Income tax expense
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57,763
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12
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60,253
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13
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168,756
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12
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167,531
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12
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Net earnings
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92,729
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19
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88,727
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19
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266,002
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19
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249,470
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18
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Less net earnings attributable to the noncontrolling interest
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329
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—
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237
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—
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972
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—
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318
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—
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Net earnings attributable to shareholders
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$
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92,400
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19
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%
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$
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88,490
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19
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%
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$
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265,030
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19
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%
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$
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249,152
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18
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%
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Airfreight services:
Airfreight services revenues increased 1% for the
three-month period ended
September 30, 2013
, as compared with the same period for
2012
, due to a 3% increase in tonnage that was partially offset by the Company lowering sell rates to reflect soft market conditions primarily caused by higher available capacity relative to demand. Airfreight services expenses decreased 1% for the three-month period ended
September 30, 2013
, as compared with the same period for
2012
, as the increase in tonnage was more than offset by improved buy rates and effective carrier utilization.
Airfreight services revenues decreased slightly and related expenses declined 2% for the
nine-month
period ended
September 30, 2013
, as compared with the same period for
2012
, as a 3% increase in tonnage was offset by lower sell and buy rates for the market conditions described above.
Airfreight services net revenues increased 7% for the three-month period ended
September 30, 2013
, as compared with the same period for
2012
. The increase in global airfreight services net revenues was primarily due to a 3% increase in airfreight tonnage and a 4% increase in net revenue per kilo. North America, Asia Pacific and Europe airfreight services net revenues increased 9%, 4% and 6%, respectively, as air export tonnage increased 3%, 1% and 5%, respectively.
Airfreight services net revenues increased 3% for the
nine-month
period ended
September 30, 2013
, as compared with the same period for
2012
. The increase in global airfreight services net revenues was principally due to a 3% increase in airfreight tonnage. North America, Asia Pacific and Europe airfreight services net revenues increased 2%, 4% and 2%, respectively, in the nine months ended
September 30, 2013
as compared with the same periods in
2012
, while airfreight export tonnage for North America, Asia Pacific and Europe increased 1%, 4% and 3%, respectively.
The global airfreight market continues to be affected by the decrease in size and weight of high technology consumer products and the timing of new product launches. Customers remain focused on improving supply-chain efficiency by utilizing deferred airfreight or ocean freight whenever possible. The Company expects these trends to continue in conjunction with carriers' efforts to manage available capacity, however, this could be affected by new product launches during periods that have historically experienced higher demands. These factors result in a higher degree of volatility in both rates and volumes.
Ocean freight services and ocean services:
Ocean freight and ocean services revenues decreased 4% and 3%, respectively, for the three and nine-month periods ended
September 30, 2013
, as compared with the same periods for
2012
, primarily driven by lower sell rates to customers, reflecting increased carrier capacity that outpaced overall market demand. Ocean freight and ocean services expenses decreased 5% and 4%, respectively, for the three and nine-month periods ended
September 30, 2013
, as compared with the same periods for
2012
, primarily due to reduced buy rates from carriers as a result of the market conditions referenced above. The decreases in sell and buy rates were partially offset by an increase in container volumes of 9% and 3%, respectively, for the three and nine-month periods ended
September 30, 2013
, as compared with the same periods for
2012
. Container volume is measured in terms of forty-foot container equivalent units (FEUs).
Container volumes increased 9% for the three-month period ended
September 30, 2013
, as compared with the same period for
2012
, while ocean freight and ocean services net revenues decreased 1%, primarily resulting from pricing reductions needed to both maintain and gain market share. Ocean freight and ocean services net revenues increased 1% for the nine-month period ended
September 30, 2013
, as compared with the same period for
2012
, primarily resulting from additional services and volumes with new and existing customers utilizing order management services. Ocean freight and ocean services net revenues are comprised of three basic services: ocean freight consolidation, direct ocean forwarding and order management. The largest component is ocean freight consolidation, which represented 44% and 46% of ocean freight net revenue for the three and
nine-month
periods ended
September 30, 2013
, respectively, and 47% for the same periods ended in
2012
.
Ocean freight consolidation net revenues decreased 8% for the three-month period ended
September 30, 2013
, as compared with the same period in
2012
, primarily due to a 16% decrease in net revenue per container, partially offset by a 9% increase in container volume. During the third quarter of
2013
, ocean carriers attempted on several occasions to impose general price increases. Ultimately, these efforts were unsuccessful and market ocean rates continued to fall throughout the quarter in the face of ongoing capacity issues. In order to maintain and grow market share, the Company reacted to these market trends by temporarily absorbing carrier cost increases, when the Company anticipated such cost increases would be temporary and could not be sustained by the carriers. The Company also implemented rate reductions with its customers where needed to reflect market conditions, mostly on exports from China. Ocean freight consolidation net revenues decreased 1% for the
nine-month
period ended
September 30, 2013
, as compared with the same period in
2012
, primarily due to a 5% decrease in net revenue per container, partially offset by a 3% increase in container volume.
Direct ocean freight forwarding net revenues increased 1% and remained constant, respectively, for the three and nine-month periods ended
September 30, 2013
, as compared with the same periods in
2012
. Order management net revenues increased 9% and 6%, respectively, for the
three and nine
-month periods ended
September 30, 2013
as compared with the same periods in
2012
, mostly due to additional services and volumes with new and existing customers.
North America and Europe ocean freight and ocean services net revenues increased 3% and 1%, respectively, while Asia Pacific decreased 6% in the
third
quarter of
2013
, as compared with the same period in
2012
. North America ocean freight and ocean services net revenues increased 3%, while Europe remained flat and Asia Pacific decreased 2% in the nine-month period ended
September 30, 2013
, as compared with the same period in
2012
. The decreases in net revenues in Asia Pacific are due to the Company implementing sell rate reductions to customers in the third quarter, which on average outpaced buy rate reductions negotiated with carriers, and was partially offset by an 11% increase in container volumes.
Customs brokerage and other services:
Customs brokerage and other services revenues increased 6% and 4%, respectively, for the three and nine-month periods ended
September 30, 2013
, as compared with the same periods for
2012
, as a result of increased volumes from existing and new customers. Customs brokerage and other services expenses increased 9% and 7%, respectively, for the three and nine-month periods ended
September 30, 2013
, as compared with the same periods for
2012
as a result of increased volume, higher buy rates and other costs in domestic time definite transportation services.
Customs brokerage and other services net revenues increased 4% and 2%, respectively, for the three and
nine-month
periods ended
September 30, 2013
, as compared with the same periods in
2012
, primarily due to higher volumes from existing and new customers. The margin percentage declined primarily as a result of domestic time definite transportation services. Customers continue to seek out customs brokers with sophisticated computerized capabilities critical to an overall logistics management program, including rapid responses to changes in the regulatory and security environment.
North America and Asia Pacific customs brokerage and other services net revenues increased 5% and 4%, respectively, in the
third
quarter of
2013
and 3% and 4%, respectively for the nine-month period ended
September 30, 2013
, as compared with the same periods in
2012
, primarily as a result of higher volumes. These increases were partially offset by declines in Europe of 1% and 2%, respectively, for the
three and nine
-month periods ended
September 30, 2013
, as compared with the same periods in
2012
, related to the ongoing economic challenges in Europe.
Overhead expenses:
Salaries and related costs increased 3% and 2%, respectively, for the three and
nine-month
periods ended
September 30, 2013
, as compared with the same periods in
2012
, primarily as a result of increases in base salaries and higher field and executive management bonuses earned as a result of increases in operating income.
Salaries and related costs and stock-based compensation expense as a percentage of net revenues are as follows:
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|
|
|
|
Three months ended September 30,
|
|
Nine months ended September 30,
|
|
2013
|
|
2012
|
|
2013
|
|
2012
|
Salaries and related costs
|
$
|
261,613
|
|
|
$
|
252,899
|
|
|
$
|
765,599
|
|
|
$
|
748,956
|
|
As a % of net revenues
|
54.3
|
%
|
|
54.4
|
%
|
|
54.8
|
%
|
|
54.9
|
%
|
Stock compensation expense
|
$
|
11,015
|
|
|
$
|
11,320
|
|
|
$
|
33,060
|
|
|
$
|
32,846
|
|
As a % of net revenues
|
2.3
|
%
|
|
2.4
|
%
|
|
2.4
|
%
|
|
2.4
|
%
|
Historically, the relatively consistent relationship between salaries and net revenues is the result of a compensation philosophy that has been maintained since the inception of the Company: offer a modest base salary and the opportunity to share in a fixed and determinable percentage of the operating profit of the business unit controlled by each key employee. Using this compensation model, changes in individual incentive compensation will occur in proportion to changes in Company operating income, creating a direct alignment between corporate performance and shareholder interests. Bonuses to field and executive management for the
nine-month
period ended
September 30, 2013
were both up 4%, as compared with the same period for
2012
, primarily as a result of a 4% increase in operating income. The Company’s management incentive compensation programs have always been incentive-based and performance driven and there is no built-in bias that favors or enriches management in a manner inconsistent with overall corporate performance.
Because the Company’s management incentive compensation programs are also cumulative, no management bonuses can be paid unless the relevant business unit is, from inception, cumulatively profitable. Any operating losses must have been offset in their entirety by operating profits before management is eligible for a bonus. Since the most significant portion of management compensation comes from the incentive bonus programs, the Company believes that this cumulative feature is a disincentive to excessive risk taking by its managers. Due to the nature of the Company’s services, it has a short operating cycle. The outcome of any higher risk transactions, such as overriding established credit limits, would be known in a relatively short time frame. Management believes that when the potential and certain impact on the bonus is fully considered in light of this short operating cycle, the potential for short term gains that could be generated by engaging in risky business practices is sufficiently mitigated to discourage excessive and inappropriate risk taking. Management believes that both the stability and the long term growth in revenues, net revenues and net earnings are a result of the incentives inherent in the Company’s compensation program.
On October 7, 2013, the Company and Peter J. Rose, the Company's Chairman and Chief Executive Officer entered into a Succession Agreement (Agreement). Mr. Rose will retire as Chief Executive Officer of the Company effective March 1, 2014 and expects to remain Chairman of the Board of Directors until the annual meeting of shareholders in May 2015. Pursuant to the Agreement, Mr. Rose will receive a retirement bonus equal to the amount he would have received under the 2008 Executive Incentive Compensation Plan (Plan) for 2014 and the first five months of 2015, assuming that Mr. Rose received the same percentage of the pool under the Plan that was used to calculate his incentive compensation for the quarter ended June 30, 2013. The Company currently estimates that the total retirement bonus will approximate $8 million and will be recorded in its entirety as compensation expense in the fourth quarter of 2013.
Other overhead expenses increased 10% and decreased 1%, respectively, for the three and
nine-month
periods ended
September 30, 2013
, as compared with the same periods in
2012
. The increase in expenses for the quarter ended
September 30, 2013
is primarily due to a $3 million increase in depreciation and amortization expenses and a $3 million increase in other operating expenses. The increase in other operating expenses resulted primarily from a larger provision for bad debts and higher legal and related expenses, partially offset by lower indirect taxes resulting from the transition to a value-added tax (VAT) system in certain jurisdictions. The lower expenses for the nine-month period ended September 30, 2013 were primarily due to a fine of €4.14 million ($5.5 million) incurred in the first quarter of 2012 related to the European Commission's finding against the Company for anti-competitive behavior and the transition to a VAT system in certain jurisdictions, partially offset by a $6 million increase in depreciation and amortization expenses as a result of investments in technology and building and leasehold improvements. Excluding the fine discussed above, other overhead expenses as a percentage of net revenues remained constant for the
nine-month
period ended
September 30, 2013
, as compared with the same period in 2012.
Income tax expense:
The Company pays income taxes in the United States and other jurisdictions. The Company’s consolidated effective income tax rate decreased to approximately
38.4%
and
38.8%
, respectively for the three and
nine-month
periods ended
September 30, 2013
from
40.4%
and
40.2%
, respectively, for the three and
nine-month
periods ended
September 30, 2012
. The decrease in the effective tax rate for the three and
nine-month
periods ended
September 30, 2013
is due to lower non-deductible expenses as compared to the prior year period and less of a negative impact in the current year period associated with the Company's stock-based compensation arrangements when compared to the prior year periods. The tax benefit related to stock-based compensation expense is recorded for non-qualified stock options at the time the related compensation expense is recognized while the tax benefit received for disqualifying dispositions of incentive stock options and employee stock purchase plan shares cannot be anticipated and is recorded at the time of the disqualifying event.
Currency and Other Risk Factors
The nature of the Company's worldwide operations necessitates the Company dealing with a multitude of currencies other than the U.S. dollar. This results in the Company being exposed to the inherent risks of volatile international currency markets and governmental interference. Some of the countries where the Company maintains offices and/or agency relationships have strict currency control regulations which influence the Company's ability to hedge foreign currency exposure. The Company tries to compensate for these exposures by accelerating international currency settlements among its offices or agents. The Company enters into foreign currency hedging transactions only in limited locations where there are regulatory or commercial limitations on the Company's ability to move money freely around the world or the short-term financial outlook in any country is such that hedging is the most time-sensitive way to mitigate short-term exchange losses. Any such hedging activity during the
three and nine
months ended
September 30, 2013
and
2012
was insignificant. The Company had no foreign currency derivatives outstanding at
September 30, 2013
and
December 31, 2012
. During both the
three and nine
months ended
September 30, 2013
, net foreign currency losses were less than
$1 million
. For the same periods of
2012
, the Company's net foreign currency losses were less than
$1 million
and
$4 million
, respectively.
International air and ocean freight forwarding and customs brokerage and other services are intensively competitive and are expected to remain so for the foreseeable future. There are a large number of entities competing in the international logistics industry, some of which have significantly more resources than the Company; however, the Company’s primary competition is confined to a relatively small number of companies within this group. The industry continues to experience consolidations into
larger firms striving for stronger and more complete multinational and multi-service networks. However, regional and local brokers and forwarders remain a competitive force.
The primary competitive factors in the international logistics industry continue to be price and quality of service, including reliability, responsiveness, expertise, convenience, and scope of operations. The Company emphasizes quality customer service and believes that its prices are competitive with those of others in the industry. Larger customers utilize more sophisticated and efficient procedures for the management of their logistics supply chains by embracing strategies such as just-in-time inventory management. The Company believes that this trend has resulted in customers using fewer service providers with greater technological capacity and more consistent global coverage. Accordingly, sophisticated computerized customer service capabilities and a stable worldwide network have become significant factors in attracting and retaining customers. Developing and maintaining these systems and a worldwide network has added a considerable indirect cost to the services provided to customers. Smaller and middle-tier competitors, in general, do not have the resources available to develop customized systems and a worldwide network.
Liquidity and Capital Resources
The Company’s principal source of liquidity is cash and cash equivalents, short-term investments and cash generated from operating activities. Net cash provided by operating activities for the
three and nine
months ended
September 30, 2013
, was approximately
$96 million
and
$346 million
, respectively, as compared with
$69 million
and
$309 million
for the same periods in
2012
. The increases of
$27 million
and
$37 million
, respectively, for the
three and nine
-month periods ended
September 30, 2013
are primarily due to changes in working capital accounts and an increase in earnings, partially offset by a decrease in deferred taxes associated with remittance of dividends from foreign subsidiaries. At
September 30, 2013
, working capital was
$1,634 million
, including cash and cash equivalents and short-term investments of
$1,410 million
. The Company had no long-term debt at
September 30, 2013
. Management believes that the Company’s current cash position and operating cash flows will be sufficient to meet its capital and liquidity requirements for at least the next 12 months and thereafter for the foreseeable future, including meeting any contingent liabilities related to standby letters of credit and other obligations.
The Company’s business is subject to seasonal fluctuations. Cash flow fluctuates as a result of this seasonality. Historically, the first quarter shows an excess of customer collections over customer billings. This results in positive cash flow. The increased activity, typically commencing late second or early third quarter and continuing well into the fourth quarter, causes an excess of customer billings over customer collections. This cyclical growth in customer receivables consumes available cash.
As a customs broker, the Company makes significant cash advances for a select group of its credit-worthy customers. These cash advances are for customer obligations such as the payment of duties and taxes to governmental authorities in various countries throughout the world. Cash advances are a “pass through” and are not recorded as a component of revenue and expense. The billings of such advances to customers are accounted for as a direct increase in accounts receivable from the customer and a corresponding increase in accounts payable to governmental customs authorities. As a result of these “pass through” billings, the conventional Days Sales Outstanding or DSO calculation does not directly measure collection efficiency. Management believes that the Company has effective credit control procedures, and historically has experienced relatively insignificant collection problems.
Cash used in investing activities for the
three and nine
months ended
September 30, 2013
was
$25 million
and
$141 million
, respectively. The Company purchased short-term investments of $10 and $100 million, for the three and nine-month periods ended September 30, 2013, respectively. In the
three and nine
months ended
September 30, 2013
, the Company made capital expenditures of
$15 million
and $
43 million
, respectively, as compared with
$10 million
and
$37 million
, respectively, for the same periods in
2012
. The Company does have need, on occasion, to purchase or construct buildings to house staff and to facilitate the staging of customers’ freight. The Company routinely invests in technology, leasehold improvements, equipment and office furniture. Capital expenditures in the
three and nine
months ended
September 30, 2013
related primarily to investments in technology, office furniture and equipment and building and leasehold improvements. Total capital expenditures in
2013
are estimated to be approximately $55 million. This includes routine capital expenditures plus additional real estate development.
Cash used in financing activities during the
three and nine
months ended
September 30, 2013
, was
$53 million
and
$142 million
, respectively, as compared with
$64 million
and
$205 million
for the same periods in
2012
. The increase in proceeds from issuance of common stock was primarily due to increased option exercises at a higher average exercise price. The Company uses the proceeds from stock option exercises, employee stock purchases and available cash to repurchase the Company’s common stock on the open market to limit the growth in issued and outstanding shares. Cash used to repurchase common stock decreased primarily as a result of the Company repurchasing an additional 1.0 million shares of common stock in the three and nine-month periods ended September 30, 2013, as compared to 1.6 million and 3.1 million shares, respectively, for the same periods in 2012. In February 2013 the Company purchased the noncontrolling interest of a consolidated subsidiary. During the nine months ended
September 30, 2013
and
2012
, the Company paid dividends of
$.30
and
$.28
per share, respectively.
The Company follows established guidelines relating to credit quality, diversification and maturities of its investments to preserve principal and maintain liquidity. The Company’s investment portfolio has not been adversely impacted by the disruption in the credit markets. However, there can be no assurance that the Company’s investment portfolio will not be adversely affected in the future.
At
September 30, 2013
, the Company was contingently liable for $99 million from standby letters of credit and guarantees. The standby letters of credit and guarantees relate primarily to obligations of the Company’s foreign subsidiaries for credit extended in the ordinary course of business by direct carriers, primarily airlines, and for duty and tax deferrals available from governmental entities responsible for customs and VAT taxation. The total underlying amounts due and payable for transportation and governmental excises are properly recorded as obligations in the books of the respective foreign subsidiaries, and there would be no need to record additional expense in the unlikely event the parent company is required to perform.
The Company's foreign subsidiaries regularly remit dividends to the U.S. parent company after evaluating their working capital requirements and needs to finance local capital expenditures. In some cases, the Company’s ability to repatriate funds from foreign operations may be subject to foreign exchange controls. At
September 30, 2013
, cash and cash equivalent balances of
$562 million
were held by the Company’s non-United States subsidiaries, of which
$74 million
was held in banks in the United States. Earnings of the Company's foreign subsidiaries are not considered to be indefinitely reinvested outside of the United States and, accordingly, a deferred tax liability has been accrued for all undistributed earnings, net of foreign related tax credits.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to market risks in the ordinary course of its business. These risks are primarily related to foreign exchange risk and changes in short-term interest rates. The potential impact of the Company’s exposure to these risks is presented below:
Foreign Exchange Risk
The Company conducts business in many different countries and currencies. The Company’s business often results in billings issued in a country and currency which differs from that where the expenses related to the service are incurred. In the ordinary course of business, the Company creates numerous intercompany transactions and may have receivables, payables and currencies that are not denominated in the local functional currency. This brings foreign exchange risk to the Company’s earnings. The principal foreign exchange risks to which the Company is exposed are in Chinese Yuan, Euro, Mexican Peso and Canadian Dollar.
Foreign exchange rate sensitivity analysis can be quantified by estimating the impact on the Company’s earnings as a result of hypothetical changes in the value of the U.S. dollar, the Company’s functional currency, relative to the other currencies in which the Company transacts business. All other things being equal, an average 10% weakening of the U.S. dollar, throughout the
nine
months ended
September 30, 2013
, would have had the effect of raising operating income approximately $29 million. An average 10% strengthening of the U.S. dollar, for the same period, would have the effect of reducing operating income approximately $24 million. This analysis does not take into account changes in shipping patterns based upon this hypothetical currency fluctuation. For example, a weakening in the U.S. dollar would be expected to increase exports from the United States and decrease imports into the United States over some relevant period of time, but the exact effect of this change cannot be quantified without making speculative assumptions.
The Company currently does not use derivative financial instruments to manage foreign currency risk and only enters into foreign currency hedging transactions in limited locations where regulatory or commercial limitations restrict the Company’s ability to move money freely. Any such hedging activity during the
nine
months ended
September 30, 2013
and
2012
was insignificant. During both the
three and nine
months ended
September 30, 2013
, net foreign currency losses were less than
$1 million
. For the same periods of
2012
, the Company's net foreign currency losses were less than
$1 million
and
$4 million
, respectively. The Company had no foreign currency derivatives outstanding at
September 30, 2013
and
December 31, 2012
. The Company instead follows a policy of accelerating international currency settlements to manage foreign exchange risk relative to intercompany billings. As of
September 30, 2013
, the Company had approximately $4 million of net unsettled intercompany transactions. The majority of intercompany billings are resolved within 30 days.
Interest Rate Risk
At
September 30, 2013
, the Company had cash and cash equivalents and short term investments of
$1,410 million
, of which $862 million was invested at various short-term market interest rates. The Company had no long-term debt at
September 30, 2013
. A hypothetical change in the interest rate of 10 basis points at
September 30, 2013
would not have a significant impact on the Company’s earnings.
In management’s opinion, there has been no material change in the Company’s interest rate risk exposure in the
third
quarter of
2013
.
Item 4. Controls and Procedures
Evaluation of Controls and Procedures
The Company carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report at the reasonable assurance level.
Changes in Internal Controls
There were no changes in the Company’s internal control over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
The Company's management has confidence in the Company’s internal controls and procedures. Nevertheless, the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s disclosure controls and procedures or the Company’s internal controls will prevent all errors or intentional fraud. An internal control system, no matter how well-conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of such internal controls are met. Further, the design of an internal control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all internal control systems, no evaluation of controls can provide absolute assurance that all the Company’s control issues and instances of fraud, if any, have been detected.